Fuel Switching Due to Rise in European Carbon Prices

In a push to make carbon pricing more effective as a means for reducing carbon emissions, the European Commission announced in May total carbon emission allowances auctioned under the European Trading System (ETS) will be reduced by 44 percent in 2019.

The announcement intended to make the Market Stability Reserve (MSR) more relevant as well. Introduced to deal with the surplus of carbon emissions credits emerging from the 2009 financial crisis, the MSR is set to maintain stable carbon prices.

As part of the announcement, the commission also decided to further reduce carbon emission by 24 percent each year from 2019 to 2023 to align with the low carbon economy road map (see Figure 1 below). The commission claims these reductions are necessary to meet 2030 and 2050 climate goals.

Even before the changes in market stability reserve kicked in, carbon prices rallied, and reached 10-year high levels of up to 25€/t since the second quarter of 2018. The surge in natural gas prices caused this record-high, which gave coal generation a competitive advantage and pushed the demand for carbon allowances. With the current carbon price already at 19 €/t, further reduction in the supply of EUAs vis-à-vis MSR is bound to create a shortfall in the market in 2019, forcing power generators to use surplus allowances accumulated during the past years, alternatively save further allowances in anticipation of rising prices, or shift to low carbon-intensive technologies for generation.

The biggest impact of these upcoming changes will be in the German electricity market, where the carbon price could go as high as 32 €/t come 2019. This can trigger coal-to-gas switching on a large scale. With such a high price, the clean dark spreads could go as low as zero, and utilities in Germany predict the power prices could go as high as 60 €/MWh. If the carbon price goes as high as 50 €/t by 2022, the German power prices could rise to 76 €/MWh. The German electricity market has limited capacity for coal-to-gas switching, which could lead to potential gas generation pushing prices even higher. The anticipated rise in carbon prices in the next six to seven years can force carbon-intensive generation technologies to be further pushed back in the merit order (see Figures 2 and 3 below).

Figures 2 and 3: The EPSI platform showcases both the current and anticipated CO2 prices. Click to enlarge

Since European electricity markets have differences in fuel stacks, the market in Great Britain won’t witness a major shift in the merit order as the majority of thermal power generation comes from gas plants. However, given the increase in carbon price, the power prices are expected to increase steeply (see Figure 4 below) unless power generators hedge the risk by banking extra emission allowances.

Figure 4: The EPSI platform shows how the increase in carbon prices will result in power price rises. Click to enlarge

If we look at the Polish electricity market, the rising carbon prices are going to hit the merit order severely, pushing a large chunk of coal power plants out of the merit order and bringing gas power plants in. In response, power prices will rise steeply.

Figure 5: The EPSI platform shows how the rising carbon prices will result in power price spikes in the Polish electricity market. Click to enlarge